Weaker Sovereign Credit Outlook Ahead of 2017

Recent research published by Moody’s in November 2016 highlights the negative outlook on sovereign creditworthiness. Currently, Moody’s credit rate 134 sovereigns. 35 sovereigns (26%) have a negative outlook compared to 12 sovereigns (9%) which have a positive outlook. The proportion is the highest since 2012 which was after the Eurozone crisis.

The negative outlook, to a large extent, is attributable to a weaker oil price that many emerging markets rely heavily on. Low inflation combined with low and negative interest rates have adversely impacted the financial stability (too low for too long) and pension systems. The savers will now require a higher saving rate to compensate for fund performance yielding less than what it was previously due to negative and low-interest rate environment.

The reduced interest rate, however, has led to improved debt affordability but does not solve the high debt level (as reflected by Debt / GDP). The low-interest rates are very encouraging to many countries, and data of Moody’s showed that only a few countries had taken this opportunity to take on more debts and increase the maturity of the bonds. Though, as the debt maturity becomes imminent, it might be vulnerable to unfavourable interest rate environment when refinancing. Sovereign credit assessment does not just focus on credit profile but also assess on how the debt can improve the growth prospects. Our opinion is that the emerging markets can take this opportunity to leverage up to close the infrastructure gap to improve efficiency and quality of life. However, it can be limited if the economies rely heavily on the oil and commodities prices as it constrains the ability to service.

Bank for International Settlements did a research in July 2011 investigating the impact of sovereign credit risk on bank funding. In order to attract the bank deposit, BIS argues that customers require a higher rate to compensate for the risks of putting money in these banks. After November 2009, Greece announced larger than expected budget deficit, CDS and the funding costs rose astonishingly. For companies with high indebtedness, it might be credit negative as it increases their probability of default and reduces their profitability (weakening the equity market outlook).

2) Elevated cost of capital will have an adverse effect on the valuation

Those with floating rates debts will eventually see their debts re-price at a higher rate resulting in higher cost of capital. It will affect the bottom line result through higher effective interest rate (after the re-pricing). Also, holding everything constant, higher cost of capital will lead to lower present value hence (higher discount rate).

3) Capital outflow to safe assets and advanced economies

Emerging markets are often viewed as riskier due to political instability, vulnerable to any negative events and the economies are not highly diversified (the list goes on). Any material change in sovereign risks might lead to capital outflow, further weakening their ability to withstand any speculative attacks on the financial systems. Moody’s research has pointed out several cases:

– The on-going tension between China and Taiwan may lead to other countries that have a strong trading relationship with China to reduce economic activities with Taiwan. – The elevated tension between Syria and Iraq has led to Turkey’s tourism industry to suffer. Noticed that sovereign risks are not necessary solely on the debt repayment ability, many considerations cannot be captured (especially there are much more factors at a country level to be considered relative to individual corporate).

Whether China will experience ‘hard landing’ or ‘soft landing’ remains uncertain. And guess what? Mr Market hates uncertainty, and it is no surprise to see capital outflows from China are increasing. The market usually allocates capital to regions or countries with high growth prospects. What is known as ‘Bao Ba’ in Chinese, meaning the government is targeting 8% growth, is unsustainable in the long run (what goes up, must come down, eventually).

SummaryMoody’s research highlighted negative outlook on many sovereigns. The market, especially the debt capital market, will eventually price this (it probably has already) into the valuation. Once the sovereign risks begin to materialise, perhaps, through a series of rating downgrade by the big 3 rating agencies and surge in the CDS, it might send the bond yield to record high (leading to lower bond prices). However, some might argue that rising bond yield is a healthy signal as it reflects positive growth outlook (the market is expecting higher future inflation).

Moody’s projected the oil price will be around $38 in 2017 (to our best knowledge), with the oil price gradually improve (now at c. $52), it may give some breathing space to countries that are highly dependent on oil price, provided it can sustain at around this price range in the foreseeable future.